Japan’s new PM

A new leader of the LDP was elected today - Shigeru ISHIBA. He will become Japan’s Prime Minister. Ishiba, a many time candidate, saw off competition from Takaichi in the last round. This result was a surprise as he had been behind Takaichi after the first round of voting. It seems that even Ishiba was surprised! Whilst always popular with the LDP party members he has finally managed to win over enough of his Diet colleagues who have been reluctant to support him before. His lack of a strong personal franchise in parliament may constrain his ability to act. It seems that the LDP was not ready to move to the next generation leaders such as Koizumi and Takaichi who so far lack senior Cabinet experience. We would expect that they both receive senior roles. They’ll be back…

Ishiba is seen as being relatively dovish on China (a more equal relationship with US policy) but as defence minister has advocated forcefully and successfully for a bigger defence budget; and in favour of fiscal steps to reduce the deficit including higher interest rates. This is a classic Ministry of Finance supported position. He is thought less interested in reform and represents a bigger change in policy stance than Takaichi would have been. In his latest book he referenced PM Ishibashi, the great rival of Kishi (Shinzo ABEs grandfather), as his inspiration and he has been personally opposed to Abe for much of his career. At the least we should assume that political pressure around a reflationary policy framework including to keep interest rates very low will be reduced giving the BoJ more flexibility.

Key policy platform points

• Yen is too weak
• Nuclear power is bad and should be stopped. No new reactors
• Tax should be higher on financial income
• Fiscal policy should be ‘disciplined’
• Change constitution to allow for a military

The immediate market response has been for the Yen to strengthen towards 142 /$ and futures to sell off around 2%.

7&i

News that one of Japan’s leading retailers and owner of 7/11 had received an approach from its leading convenience store competitor Couche Tard (ACT) was a big boost to the market for corporate control in Japan. 7&i has long been two businesses - a world class global CVS chain and its struggling domestic supermarket, department store and other retail assets - which traded at a large conglomerate discount. Deeply entrenched management and a weak board have allowed this situation to persist over any years.

We have previously owned the stock as prospects for unlocking this value seemed brighter with the engagement of a US activist fund. Management did reform the board and had agreed in principle to separate the group into pieces however the glacial pace of change fuelled by fierce internal opposition to change and challenging trading encouraged us to exit. The value was present but the positive catalyst that we require was not. ACT took advantage of the weak share price and has proposed a takeover. Whilst details are few we would expect that they will sell off non CVS assets to help fund the deal, along with new equity and a hefty slug of debt. This proposal is not that different from what so many investors have been asking management to do for 15 years… at this stage the company risks lowing control of the pace of change.

Our sense is that the price is not high enough; that management can probably promise enough self help and there are enough anti trust obstacles that cast doubt on the deal to maintain 7&i’s independence. However, the management team is now ‘on notice’ and their flexibility is gone. Sympathy is not in order as they have had at least a decade - two! - to address their operational challenges, group structure and low valuation. That they have failed to do so despite frequent, strong requests for change means that they have only themselves to blame. We often say to firms that if they do not act voluntarily there is a good chance that other prospective owners will force their hand. I’m sure that 7&i management now wish that they had listened to shareholders more closely and moved faster in response.

Despite the higher share price in recent days selling 7&i was the right decision. The weak operational execution and lacklustre commitment to reform have led the shares to underperform the broad market over not just the last year but also over many years. The big risk in investing in such a value situation is the length of time it takes to play out. The opportunity cost of owning structurally underperforming shares is very high in a market where so many others are taking proactive steps to improve returns and look after shareholders.

20.08.2024/155

Japanese Market: The Last Two Days

Japan fell heavily for a second day. This is the worst day that the Japanese stock market has experienced in 8 years and the worst two day move since the Tsunami in March 2011. The broader benchmark has fallen close to -10%.

Worst day in 8 years for Japanese stocks:
^{Topix index, daily % change}

Source: LSEG

Value has marginally underperformed growth as a style. Our latest report: Base Camp reached…now the hard partargued that further upside short term in the market might be challenging as certain segments of the market had become significantly overbought. We argued that the Yen was trading at the wrong price against the dollar and sterling and that small caps would outperform.

Over 35 years covering Japan I am never surprised by the types of moves we have witnessed in the last two days. We have warned that a stronger Yen currency would initially cause indices to fall. What has been more difficult to gauge is the extent of the Yen carry trade. This week the Bank of Japan raised interest rates to 0.25%. This comes at a time when the both the Federal Reserve and the Bank of England look to be moving towards an easing cycle. The Yen has moved from over ¥160/$1 to the current level of ¥149/$1.

The yen is strengthening after hitting a 38-year low in July

Source: LSEG 

My co-manager David Mitchinson reminded me today about simply not knowing the extent of potential carry trade unwind. The BOJ has clearly come under a lot of pressure from the likes of LDP digital minister, Taro Kono regarding imported inflation and this newfound “hawkishness” is somewhat precarious. It comes at a time when the US economy looks vulnerable to weaker employment and consumption and a Chinese economy that has so far failed to bounce back. The two-day sector losers have included Brokers (-15%), Insurance (-14%), trading Companies (-11%), Auto’s (-11%) and Technology (-10%). These are all “overcrowded” trades that have seen foreigner’s pile into. The scale of hedge fund involvement and structured fund involvement is just not known.

Where to from here? A stronger Yen now seems likely. This will lead to a bifurcated market where perhaps the “winners” of the last year bounce short term but thereafter struggle. Many of these names are Yen sensitive and exposed to the global economic cycle. Our portfolio remains very domestically orientated. We will nibble at some existing names that have pulled back but are cognisant that the deleveraging may have further to go in certain names.

On a more positive note, we have managed to pick up some relative performance during this sell off. Our concerns around positioning, valuation and overexuberance are all short term concerns that do not detract from our longer term optimism on capital allocation change in Japan.

 02.08.2024/147.

Bank of Japan Announcement

The Bank of Japan has increased its interest rate from between 0 to 0.1% to “around” 0.25%. This is only the second hike in 17 years. It marks the last central bank in the G7 finally shifting to a normalisation of monetary policy from quantitative easing. Mr Ueda also announced plans to halve its bond purchases. Amazingly, 0.25% is the highest interest rate since 2008. If prices continue to rise the bank indicated that rates will go higher. At Zennor we feel that this announcement was somewhat more hawkish than most commentators had expected. What then is a neutral rate? Insiders tell us that the Ministry of Finance have assumed a 1.5% interest rate assumption one year out in their revenue/expenditure models. The 10-year long bond yield stands at 1.05%. The Bank of Japan added that prices and economic activity have been developing in line with their assumptions earlier in the year. They pointed to a good outlook for capital expenditure and strong profits growth. Wage hikes have boosted consumption and have begun to spread to smaller sized companies. Despite the hike in interest rates real rates remain firmly negative. The following quote from the BOJ website is instructive. We believe that Mr Ueda has come under intense pressure from the government and Ministry of Finance regarding the collapse in the yen.

“As for the future conduct of monetary policy, while it will depend on developments in economic activity and prices as well as financial conditions going forward, given that real interest rates are at significantly low levels, if the outlook for economic activity and prices presented in the July Outlook Report will be realized, the Bank will accordingly continue to raise the policy interest rate and adjust the degree of monetary accommodation”.

Sometimes, we at Zennor have sounded like a broken record. We have consistently said for two years that the yen is mispriced. We apologise, as we have been wrong. However, our central argument that inflation was somewhat more entrenched has been proved right. What we have also highlighted is the huge yen carry trade and the risk that this could have on global financial assets. We think that this exit from the yen carry trade has only just begun. This, as we have argued has huge ramifications for sector selection and stock selection. Both funds have a large skew towards domestic sectors and small and mid-cap shares. Our Yen sales weight is 75% for both funds. This compares to a 55% for the broader market.

02.08.2024/146.

New share buybacks announced by portfolio companies

The parent business Sanken Electric (6707) is relatively a mediocre business that manufactures Discrete Integrated Circuits used in electrical appliances like air conditioners. However Sanken own 51% of a good company in the USA called Allegro Microsystems in the Power Integrated Circuit space. The numbers are ludicrous. Sanken’s market cap is ¥205bn. The Allegro stake is worth ¥390bn. Net Debt is ¥90bn. Today, the company announced 38% of its holding will be sold raising ¥146bn. This will be used to pay down debt and buy back shares. The shares are up 19% so far in July. Link to the announcement: https://www.sanken-ele.co.jp/corp/en/news/ir.ht

We really like Canon Marketing Japan Inc (8060). It is a closet IT software company and also a Canon distributor. The software side has been seeing +15% growth at the operating level in the recent quarter. Canon Inc agreed today to sell 20m shares of its 75m share stake in Canon Marketing Japan at ¥4091 per share. Canon Marketing will repurchase up to 22m shares representing 16.78% of the company and then cancel those shares. Earnings per share should rise 15%.

These are further examples of the corporate governance revolution in action.

29.07.2024/145.

News: The Yen

The Yen is having a bit more of a bounce. From ¥161.5 to the US$ we are now at ¥156. Whilst you never quite know why now we can highlight some FX intervention. This is both in market and also open mouth comments from senior politicians such as Taro Kono. Kono has a big mouth but has probably been given some licence to say that Bank of Japan should raise rates to stabilise the Yen. There is a growing view in Japan that a too weak Yen is just as harmful as a too strong Yen. We doubt any companies would be seriously impacted at ¥140 or even ¥130, which is what simple interest rate spread models would suggest. Goldman Sachs estimate that their fair value is sub ¥100/$.

We have been wrong on Yen direction for at least the past 18 months but with other global Central Banks now thinking about rate cut timing the Bank of Japan is still focused on normalising their negative real rates. Our view has been that as interest rate differentials tightened the attraction of JPY carry trades would diminish.

A stronger Yen may have some negative impact on exporter translated earnings but it should also boost our domestically exposed earnings streams. We suspect that this may also help smaller cap names performance against their export sensitive large caps. The fund remains 60-70% <$5bn market cap. 

Exited: Nippon Soda (4041)

Nippon Soda has been a mainstay holding in the Zennor Japan Fund since June 2022 and a holding that has made the fund close to 30%. We also bought it for the Income fund at launch. The company has doing a great job on communication to shareholders, it also has a good balance sheet, great dividend and a much-improved ESG disclosure. We began to worry that there are some near term negative catalysts caused by the inventory overhang in the agrochemical markets in Europe and South America. They have enjoyed an almost perfect business environment with their equity accounted Brazilian affiliate Ihara, and significant gains in market share in Europe. The long-term outlook is structurally very positive but the poor guidance they put out for this fiscal year after we sold has been justified. This is a stock that we will revisit, but for the time being we are happy to be sitting on the side lines.

New Position: Hachijuni Bank (8359)

When we launched the Zennor Japan Fund in February 2021, we were able to buy city banks on less than 0.4x price to book ratios. Hachijuni was bought in early March 2024 to take advantage of a bank still trading on less than 0.5x book. This large regional bank is based in Nagano Prefecture. Long term investment securities are 140% of market capitalisation. Two well known activists are now involved and in May they announced a 2% share buyback. With MUFG now trading above book value we again look forward to better corporate governance news and wider net interest margins as monetary policy is tightened. At the time of writing it is a little over a 2% position.

New Position: Toda Corporation (1860)

A better outlook for building construction and civil engineering, plus booking significant gains on real estate holdings augurs well for the coming fiscal year. Visited by James in January, the company has many deep value characteristics. Net cash, long term investment securities and unrealised gains on real estate come to 54% of market capitalisation. If one adds in net receivables the figure comes to 84%. The jewel in the crown is the Toda building which is due to be completed in November. This should add ¥5bn in income with 100% occupancy on day one. We are also at the beginning of a long journey regarding shareholder returns.

Stop Press: Early signs are encouraging with a new share buy back announced in May 2024.

Insurance companies are forced to divest shares

On the 26th of December the 4 large non-life insurance companies were issued with a business improvement directive following violations of anti-trust and governance failures. The companies are due to submit these plans by the end of February 2024. Usually in Japan this kind of order is met with a small fine, a shaming public apology and tweaks to the business process. This time their regulator, the FSA, has reputedly also asked them to unwind at least 80% of their large strategic equity holdings as they believe that this has led to conflicts of interest in terms of how they managed their businesses. This logic clearly applies to many other sectors as well.

This forced equity disposal would improve governance, raise RoE and lead to higher shareholder returns. It is also a sign that it is not just the TSE in Japan that is keen to improve governance.Following on from this request Sompo Holdings (8630) has said that they will fully exit their strategic shareholdings. Our holding MS&AD (8725) has the largest portfolio compared to its market cap and hence should see the greatest impact compared to industry leader Tokio Marine (8766) and Sompo. MS&AD only trades at book, 11x earnings and has a good chance of delivering a high teens RoE after balance sheet ‘slimming’ which suggests continued material undervaluation despite the recent move up in the share price.

16.02.2024/107

Koike Sanso

The company is involved in cutting tools used in a variety of industries such as construction, steel, shipbuilding, and heavy industry. The company produce gas, plasma and laser cutting tools. Market Cap ex treasury is ¥16.1bn, so Zennor’s smallest stock. It resides in our Income Fund. It has cash of roughly ¥22bn or over 140% of market capitalisation. In addition, there are some unrealised gains on real estate. Founded in 1929, these could be considerable. Order backlog is at record highs. Over 25% of sales come from abroad. The USA and Asia account for most of the overseas sales. Koike Aronson, based in New York has an excellent website. The parent business makes an operating margin of only 5.5% with the consolidated add on having sales of ¥20bn and an 8% margin. The weaker yen should be making it easy on the consolidated subsidiaries to import core parts from Chiba and Hyogo manufacturing bases.

Recent results are impressive. Net profit for the first half was revised up by 60%. Assuming they revise the full year by the same amount as the half year beat the shares trade on 6X price to earnings ratio and stand at a 55% discount to book value. James hopes to visit them in Tokyo in January 2024. The free cash flow is about ¥3bn. So, on market cap alone the yield is 20%. Rarely do you find companies this cheap. The technology is genuinely very impressive. I suspect this is a perfect MBO example. There is no real reason for listing as the family and related parties appear to own close to 50% of the free float. The shares yield 3%.

Upside is Considerable. No reason it can’t double.

13.11.2023/175

Bank of Japan

Today the Bank of Japan took one further step to normalising Japanese interest rates. Whilst the market’s initial reaction was one of mild disappointment we view this as setting the ground for further change next year and a balance between those who wanted no action and those looking for bigger change.

What happened?

The BoJ indicate that their Yield Curve Control policy was not rigidly fixed at 1% but was now a ‘range’ around 1%. Effectively this abandons the YCC policy as a binding policy constraint.

The Bank of Japan increased their inflation outlook for 2023 (2.5->2.8%) and 2024 (1.9->2.8%) - substantially over 2%. This would mark three consecutive years of >2% inflation. However it has retained 2025s outlook at 1.7% which maintains a more dovish policy tilt. IE they are indicating that although 3 years of >2% inflation is likely to be achieved this is not yet firmly embedded. Their preferred core core CPI measure remains just under 2% reinforcing this message about core reflationary pressures being slightly below their target level.

The key change for us was not the YCC ‘tweak’ but the uplift in inflation outlook that emphasises that the BoJ reflationary policy is working AND that more work remains to be done. We suspect this sense that the BoJ will remain accommodative for longer was what nudged the Yen lower today. Tactically this makes sense but misses the strategic shift that EXIT is now coming.

This step has significantly weakened the logic around YCC and has moved the BoJ decisively towards an exit of YCC. Economists now expect further action but it is unclear whether NIRP or YCC will be ended first. The key determinant of further change will be the Spring Shunto wage round where the BoJ highlighted this explicitly as a key factor in their thinking about inflation durability.

Taken together this combination of changed inflationary  expectations and flexibility in the long end of the curve clearly sets the BoJ on a normalising path even if the tweak today fell short of what some had been pushing for.

At a stock level this has limited direct impact on earnings but a change in short rates would be very impactful for financials and for regional and deposit rich banks especially. It would also substantially help those companies with large cash positions.

Goldman Sachs has estimated the net income profitability impact of short term rates moving up to 0.5%. We have exposure to Rakuten Bank and t Japan Post – two of the most rate sensitive financials. The impact on profitability should be in excess of 50% and possibly much more. We also own a number of regional banks that are especially geared to higher rates (and capital structure reform) but not covered by GS.

01.11.2023/171

Panasonic

There is a perception that Japan has always been a country where financial institutions and their customers have been bound together by mutual cross-shareholdings and that shareholders are subservient to managers and should be quiet passengers on a company’s voyage. This passivity was the natural order of things in Japan. But it hasn’t always been this way…

Mr Matsushita, the legendary founder of what is now Panasonic (6752) and sometimes called “the God of Japanese management”, certainly saw things very differently. Writing half a century ago during the great Japanese economic boom he said:

“…corporations are not the property of presidents or executives, but of shareholders. At the same time, companies are also “public institutions” of society. Executives report their performance at the shareholders meeting every fiscal year, and when it is good, they receive praise and appreciation from shareholders. When performance is below expectations, executives should humbly accept the harsh complaints and criticism they receive. This is the way corporations were meant to be. Managers should never forget that shareholders are their masters. As for shareholders, for them it is important not to resort to short-term trading, but rather to maintain an undaunted stance and fulfil their role as the ”central actor” of the corporation. Shareholders’ behaviour is admirable when they do not merely hold stocks and quietly receive dividends, but rather, when they warmly encourage and rigorously guide management with authority, and provide insights as shareholders…..”

Zennor would like to heed Mr Matsushita’s sage advice and will continue to ‘warmly encourage and rigorously guide… and provide insight’ to our investments. This is true engagement and helps us understand that the Revolution in Corporate Governance is really a conservative revolution of bringing things back to how they should be.

17.10.2023/165

Arealink

We recently revisited Japan’s largest self storage room operator - Arealink - and formed a very positive long term outlook for the business. We decided to follow up with CEO Suzuki and Founder/Chairman Hayashi to understand how the model has evolved and especially how they are addressing the key challenge that the company has encountered over time - volatility driven by its development activity. The changes that they have introduced over the past few years will push the company away from large, expensive, buildings towards container type storage that is much cheaper and that offers far higher returns. This evolution will allow them to scale back the capital intensive development activity and focus on growing through internal cash flows. From our perspective this means that a volatile top line has masked a strongly growing underlying revenue stream and will turn into a much more stable growth trajectory and allow other investors to appreciate the attractiveness of their business model. Freeing up this lumpy investment capital will also enable them to accelerate their core storage unit openings.

The market opportunity in Japan is still underdeveloped. Utilization rates/population are far lower. Whilst a full move to US levels of usage is unlikely it does suggest an addressable market that can expand several times over the medium term.

Source: Arealink

Arealink intends to address this storage opportunity by rapidly growing its presence. It is already the market leader with 20% share but believes that it can exceed market growth.

Source: Arealink

The economics of these smaller units are also far better. The time to profitability is under 6 months, whereas large buildings may take up to 43 years to break even and often struggle with low occupancy. The management of these units is also handled remotely whereas buildings require staff to be on hand further increasing costs.  Arealink manages around 2000 locations with just 70 employees.

Source: Arealink

One benefit of their market share and their nationwide footprint is that they have extensive data which new CEO Suzuki is using to enhance yields and to help identify attractive locations for new units. This includes enhancing the customer experience with digital keycards, courier services and storage rack rental. Small competitors cannot offer these enhanced services. Arealink is the first storage company in Japan to allow customers to sign up online and to pay via credit card. This may seem straightforward but is just another example of how they are different from their domestic competitors. These numerous small edges compound into being a large moat. Their distinctive branding and almost unique nationwide coverage along with online digital marketing means that they are usually one of the top ranked sites when customers are looking for storage.

The company has also participated in several TV shows such as this one… The other conclusion having watched the video is that Japanese storage units are MUCH tidier!

Source: Arealink

We think that this backdrop of a strong model and significant growth runway is not appreciated. With over 80% of revenue coming from recurring stock businesses this should be a highly predictable and highly valued revenue stream but it is not seen as such today. Why? History!

The company previously had a large ‘flow’ business doing development, and brokering real estate. At times this was highly successful but in other periods it slumped and caused losses. Eventually the company realised that their core rental storage business was by far their most attractive one and that they should focus on this. This business has grown for 20 years and without the volatility driven by the flow segments. These are now expected to decline as a proportion of revenues and the company is strategically deemphasising them (no more large scale development, no more storage unit brokerage etc.). This should radically reduce the volatility of earnings but is something that is hard to see today given the volatility from COVID and due to the drop out of these volatile revenues between 2019 and 2021. We think that this uncovered company has simply been ignored by many investors due to its small size (35bn), and non-core business volatility.  We do not think that this anomalous situation will last long!

Source: Arealink

Catalysts?

• Current trading is strong so they are highly likely to revise up earnings and also dividends
• Openings and pipeline are progressing ahead of plan
• Further progress in expanding stable revenue % vs. flow business
• Further exit of some non-core assets that can accelerate growth in per share value
• Improved coverage – the company is working to attract investors and also analysts after they have made these business model refinements and improved growth stability

Zennor will share the Arealink story with some other likeminded investors…

Intrinsic Value?

Our investment case as a buyer today is that the company will compound earnings at a 10%+ CAGR without recourse for additional equity capital. Dividends will grow at the same rate or higher bolstering the running yield from the current 2.4%.

As the business model stability is reappraised we believe it can rerate to 15x EBITDA. The current 7x EBITDA stands in contrast to global peers such as Shurguard 21x, Storagevault Canada 25x, Public Storage 15x or Lok N Store 18x. Unlike those firms Arealink is not heavily indebted AND is growing very quickly.

Taking a five year view we expect the company to have an intrinsic value of approx. 150bn JPY against today’s 35bn. This implies a >25% compound total return. Even if it does not rerate Arealink should still deliver a mid teens compound return if we are roughly right.

This may seem like a high IRR but our assumptions imply that the company does not hit their own unit opening targets (they are ahead), the firm does not raise prices (when inflation is back) or misses its utilisation assumptions (very stable for many years) and that it also continues to trade at a -25% discount to relevant global peers (we shall have to see!). We also do not assume any M&A which is possible...

05.09.2023/153 

New Position: Seikitokyu Kogyo (1898)

We took a 3% position in Seikitokyu Kogyo. We were attracted to this construction company given a low price to book and over 50% of its market capitalisation tied up in cash, securities and net receivables. An activist investor has also been involved in calling for higher returns. During the market today the company announced full year results and forecasts. Full year forecasts suggest the company is on 10X Price to Earnings ratio. The combined push from shareholders and the moves by the TSE to unlock value and raise the price to book have caused the company to discover real shareholder awareness. They have announced a 100% future dividend pay-out ratio and a minimum 8% dividend on equity. Fantastic! That gives us a yield of 8%. Just what we need for our Japan Income story!

24.05.2023/130